When you first encounter this prompt for your product key, just hit next and proceed with setup.

Choose which version of Windows you have purchased, check the box and click Next.

Once the first install of Vista is completed and you start the second install from within Vista, you'll need to enter your product key.

Choose "Custom (advanced)" to perform a clean install.

Once the second install of Vista has been completed, you can activtate your installation through Microsoft.

Microsoft internal documentation reveals workaround for Vista Upgrade DVDs with no need for a previous version of Windows

DailyTech reported on Monday that Microsoft no longer
performs disc checks during an operating system install.
In the past, when performing a clean install, a user could boot from an install
CD and insert a disc from a previous version of Windows for upgrade compliance.

However, per Microsoft's new licensing requirements for Vista, users
are required to install a Windows Vista Upgrade from within Windows XP. When
this occurs, the Windows XP license is forfeited and the Windows Vista installation
process can take place.

This workaround allows users to perform a “clean
install.” The process is a bit tedious, but is not hard at all to complete. Users have to perform these simple steps to perform a clean install
of Vista without a previous version of Windows installed with an upgrade DVD:

Boot from the Windows Vista Upgrade DVD and start the setup program.

When prompted to enter your product key, DO NOT enter it. Click "Next" and proceed with setup. This will install Windows Vista as a 30-day trial.

When prompted, select the edition of Vista which you have purchased and continue with setup.

Once setup has been completed and you have been brought to the desktop for the first time, run the install program from within Windows Vista.

This time, type in your product key when prompted.

When asked whether to perform an Upgrade or Custom (advanced) install, choose Custom (advanced) to perform a clean install of Vista. Yes, this means that you will have to install Vista for a second time.

Once setup has completed for the second time, you should be able to activate Windows Vista normally. You can also delete the Windows.old directory which contains information from the first Vista install.

There's no telling why Microsoft left this loophole wide
open with Windows Vista Upgrade DVDs, but this means that any retail upgrade
DVD can be used as a fully functioning full retail copy of Vista.

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OEM is a bit cheaper, but retail upgrade will allow you to switch to 32 or 64 bit. For my money I'll probably go upgrade as well. Hopefully in a year or so 64-bit drivers and software support will improve and I make the change. (last time I checked there wasn't a driver for my old photo printer yet)